In Royalty We Trust

In last Tuesday’s Rude Awakening, we examined BlackRock
Global Energy and Resources Fund (NYSE: BGR), a unique
closed-end fund that specializes in high-yielding natural
resource securities. Like the managers of BGR, we also love
high-yielding resource stocks, especially the type known as
royalty trusts.

Even though we believe the big bull market in natural
resources is going to flourish for many more years, nothing
goes up in a straight line. So we don’t mind receiving some
steady dividend income along the way.

Royalty trusts, also known as income trusts, convert
operating assets like pipelines or coal terminals or oil
fields into utility-like vehicles that pay high dividends.
The primary goal of the trust is to provide long-term
income to the unit holders, rather than capital gains. To
that end, income trusts distribute most of the cash flow
generated by the income-producing assets they hold.

There are many types of income trusts. The most well known
are probably REITs (real estate investment trusts) and oil
and gas trusts. There are also specialty trusts involved in
many different businesses, holding a wide range of assets.

The Pembina Pipeline Income Fund (Toronto: PIF-U), for
example, operates oil and gas pipelines, Westshore
Terminals Income Fund (Toronto: WTE-U) operates coal
terminals in British Columbia, Algonquin Power Income Fund
operates hydroelectric facilities in Eastern Canada and New
York.

Or if investing in canned sardines, fish meal and fish oil
appeals to you, The Conners Bros. Income Fund (Toronto:
CBF-U) provides a means of doing so. In short, there are
almost as many sorts of income funds as there are
industries.

Investors may buy or sell income trusts just like any other
stock. While income trusts can offer significant capital
gains under the right circumstances, their historic
attraction has been yields.

On the face of it, therefore, an income trust paying out
substantial yields looks like a great deal. But there are
real risks to think about, and a few key points to consider
carefully before investing.

The first point of consideration is the long-term outlook
for the underlying assets of the trust. In other words, do
the assets and/or business model of the trust ensure the
trust’s ability to thrive at least another 10 years down
the road, if not longer? Or is the payout ratio self-
destructive?

U.S.-based energy trusts are designed to produce until
reserves run dry and then call it quits. On the other hand,
Canadian energy trusts — widely known as "CanRoys,"
shorthand for Canadian royalty trusts — are allowed to
extend the life of the trust through acquisitions or
exploration. As the reserve life of current assets
depletes, many CanRoys will issue additional shares to fund
expansion. This activity can dilute value quickly if the
new purchases are not made wisely. If production in the new
areas is below previous standards, or more expensive to
operate or too costly a purchase, then unit values and cash
distributions are both likely to suffer.

Some investors are skeptical of the energy trust business
model purely because of depletion concerns. In reality,
though, traditional oil and gas stocks have to deal with a
similar issue. Unless their managements of Exxon, Shell and
BP plan to close up shop and ride off into the sunset one
day, they, too, must replenish their proven reserves over
time. So the issue of depletion really comes down to
current levels of reserves (how many years are left in the
tank) and the ability of management to profitably replenish
those reserves (through exploration or acquisition or
both).

Therefore, when it comes to income trusts generally — and
energy trusts in particular — there are certainly a lot of
concerns to address. But then again, the same story holds
true for an investment in common stock or corporate bonds.
Due diligence is always warranted.

On the positive side, because these issues come down to
quality of assets and quality of management, a well-run
energy trust can be a sound investment. A quarterly or
monthly dividend can provide income where many speculative
E&P (exploration and production) stocks would offer none,
and there is still room for upside appreciation as energy
prices rise in the long term. Because of their commitment
to distribution, energy trusts are not quite as volatile as
E&P companies that retain all earnings (though the level of
volatility for anything related to energy these days can
still be significant).

All else being equal, we favor the CanRoys that retain a
large portion of their cash flow to fund future investment.

To explain the importance of the payout ratio for income
trusts, we’ll turn to the Oracle of Omaha, Warren Buffett.
In this excerpt from a 1984 letter to shareholders, Buffett
describes the concept of "restricted earnings":

"Dividend policy is often reported to shareholders, but
seldom explained. A company will say something like, ‘Our
goal is to pay out 40–50% of earnings and to increase
dividends at a rate at least equal to the rise in the CPI.’
And that’s it — no analysis will be supplied as to why that
particular policy is best for the owners of the business.
Yet allocation of capital is crucial to business and
investment management. Because it is, we believe managers
and owners should think hard about the circumstances under
which earnings should be retained and which they should be
distributed.

"The first point to understand is that all earnings are not
created equal. In many businesses, particularly those that
have high asset/profit ratios, inflation causes some or all
of the reported earnings to become ersatz. The ersatz
portion — let’s call these earnings "restricted" — cannot,
if the business is to retain its economic position, be
distributed as dividends. Were these earnings to be paid
out, the business would lose ground in one or more of the
following areas: its ability to maintain its unit volume of
sales, its long-term competitive position, its financial
strength. No matter how conservative its payout ratio, a
company that consistently distributes restricted earnings
is destined for oblivion unless equity capital is otherwise
infused."

Buffett is talking about dividend-paying stocks, rather
than income trusts, but his point is highly relevant to
income trusts nonetheless. In order to survive and thrive
for the long term, most businesses need to reinvest a
portion of the cash they generate. If all the cash is paid
out to shareholders, the business will eventually weaken
and die. Because they are focused on cash distribution,
income trusts typically pay out anywhere from 50–90% of
earnings, and sometimes more, to shareholders. There is
thus real risk, as Buffett points out, of the underlying
business spending itself into oblivion. If the income trust
is treated as a cash cow, rather than as an ongoing
concern, then the cow is in jeopardy of being milked dry.

This is why an attractive yield is only the tip of the
iceberg. An income trust boasting a juicy short-term return
may look great at first glance, but horrible on closer
inspection. If the underlying business is throwing off cash
to shareholders but slowly being ground down by lack of
reinvestment, returns could suffer sooner rather than
later, sending the trust into a downward spiral.

Given the concerns and potential pitfalls, "reaching for
yield" without examining key factors could be dangerous.

Come back tomorrow and I’ll tell you about one of my
favorite royalty trusts.

Natural gas looks like a buy, according to Kevin Kerr,
editor of the Resource Trader Alert, at least relative to
crude oil.

"Even as crude heads higher," Kevin notes, "natural gas has
slumped lower. The reason: Though record heat is breaking
across major population centers of the country right now,
official forecasts call for the heat to break soon. If that
happens, the demand for natural gas should go down. But
here’s a question: What if the cooling breezes don’t come?
In fact, so much bearishness is built into the natural gas
market that even a mild disappointment in the weather would
burn the natural gas short-sellers."

Furthermore, as the chart above illustrates, the price of
natural gas is quite low relative to the price of crude
oil. No automatic connection between these two energy
sources would guarantee that the gas price would move
higher immediately. But on the other hand, a relatively low
gas price makes for a relatively attractive entry point to
buy the stuff…or to buy natural gas-related stocks.